2018 was a tough year for the EUR/USD exchange rate. After a false start in January, the euro fell from its high of 1.25 versus the dollar to 1.14 by year end. The pair had to contend with a number of pressures including an up-rating of the market’s expectations around US monetary policy, US-centric trade disputes, and of course fiscal risks emanating from Italy. The prospect of future interest rate normalisation and end of QE purchases by the ECB, understandably, did little to reassure investors. As the year closed however, US economic exceptionalism began to fade, the Federal Reserve switched off ‘autopilot’ in response to market turbulence, and there was some long-awaited positive news relating to China-US trade tensions. The Italian government even struck a deal with the EU over its 2019 budget.
Perhaps things are now looking up for the euro in 2019. In chart 1 we show the historical EUR/USD exchange rate as well as some other pertinent information: Purchasing Power Parity (PPP) fair value, and a range of forecasts from a panel of ten sell-side banks. If these forecasts are taken to reflect the market consensus, then the euro is expected to range-trade in the first quarter of 2019, before rising through the rest of the year. Although the consensus is rarely correct (often for good reason, as the formation of price expectations can often be a factor which instructs policy change), it is instructive both to understand why the consensus is as it is, and to also think about the factors that markets could be under or overpricing. Taking these questions in turn:
What could be the main factors explaining the consensus?
- A narrowing of economic activity and policy rate differentials: The combination of more restrictive Federal Reserve policy and an expected fading of the fiscal impulse from Trump’s tax policy are likely to usher in a period of lower growth in the US. In 2019, annual growth is expected to fall from above 3.0% to between 2.0-2.5%. The Eurozone had a tough 2018, however growth rates are expected to stabilise and even rise marginally in 2019. Relatedly, the Federal Reserve is approaching neutral levels of policy rates, while the ECB, notwithstanding unexpected shocks, may this year raise rates for the first time since 2011.
- Supportive valuations: Relative monetary policy cycles, the re-emergence of political risk in the Eurozone, and lower inflation in the Eurozone relative to the US (increasing the purchasing power of the euro) have all helped to drive the euro to quite substantial levels of undervaluation versus the US dollar. When measured by the OECD’s measure of PPP, the euro stands at c.17% undervalued. Valuation differences of these magnitudes may be enough to incentivise international goods arbitrage and speculative positioning, both of which could help to drive an adjustment of the exchange rate.
- A strong external sector: The Eurozone maintains a sizeable current account surplus of c.3% of GDP, in stark contrast to a deficit, pre-2012. If these excess savings are not recycled abroad, the euro must appreciate. Since the onset of QE in the Eurozone, aggressive outflows, primarily to the US, were enough to drive the euro almost to parity versus the dollar. With the Eurozone’s large external surplus, it is not inconceivable that even a small reversal of these capital outflows – driven by the end of QE and potentially rising rates later in the year – would help support the euro (chart 2).
What are the downside risks to the consensus?
It would seem so far that the outlook for the euro is rather rosy. The average forecast is however a composite of a wide range of potential outcomes and there are a number of factors which could upset the euro’s outlook. Below are just a few of those possibilities:
- Italian political and fiscal risks re-emerge: Italy and the EU managed to strike a budget deal late last year, covering Italy’s spending plans for 2019. For now, this looks to have pushed any acute break-up or redenomination risk further out to the future. But the risks remain. Italian growth has recently taken a turn for the worse, not helped by political toing and froing, and this will eventually start to play on the minds of European policymakers. Italy escaped all aspects of the excessive deficit procedure this time, but slowing growth affects debt sustainability (due to nominal growth rates not matching interest payments) and would also – based on the latest budget agreement – trigger an automatic increase in VAT. Either of these could become a source of renewed hostilities.
- Anaemic Eurozone growth: Real exchange rates are heavily influenced by relative real growth rates, and a protracted slowdown of the Eurozone economy could be just the factor which prevents an exchange rate adjustment back to PPP fair value. A look into the contributors to Eurozone growth shows that although supported by steady consumption, foreign trade has been a large swing factor, driving down growth. Europe’s largest export markets are the US and China, both embroiled in a lengthy trade war. The Eurozone risks being caught in the crossfire, or even being dragged into the war, should President Trump decide to place tariffs on European auto exports. Without trade-driven growth, the Eurozone must deliver it internally. To this end, hopes of Eurozone reform are fading and EU parliament elections in May are unlikely to reassure investors if populist parties are to do as well as expected.
- Delayed ECB normalisation: Most of the positive expectations around the euro are predicated on some kind of relative economic restoration, and the associated normalisation of ECB monetary policy. This cannot be relied upon, and the market’s cautious pricing of rate hikes reflects this. Growth may disappoint, disinflationary forces might take hold, or the US economy might have a hard landing after all. All of these would have the potential to derail normalisation.
It is never easy to predict what a currency will do, and the euro is no exception here. We can probably conclude that the market outlook is cautiously positive, but that a number of hurdles will need to be cleared before the euro is free to converge towards Purchasing Power Parity. Nonetheless the risks described above hopefully serve as a non-exhaustive (I think Brexit goes without saying) checklist of factors to watch out for in 2019.
Source: Record, Macrobond.